The first quarter of 2018 is over and it has proven to be somewhat more eventful than the whole of 2017. The equity momentum that persisted during 2017 carried over to January, until the final few days of the month when growth, inflation and interest rate rises came onto the agenda with a vengeance. While non-farm payroll numbers released by the US Labor Department on 2 February 2018 were only moderately higher than expected (200k vs 180k consensus), an increase in average hourly wages of 2.9% year-on-year was also reported, the largest gain since 2009. This spurred investor expectations that the Fed would hike rates sooner and higher than originally expected, resulting in four days of panic trading. On 5 February US equities suffered their worst day since the onset of the euro crisis in 2011, while US Treasuries whipsawed with 10 year Treasury yields falling by 0.15% to 2.70% in less than 30 minutes before rising to four year highs later in the month.
“The very definition of a bubble”
After an unprecedented period of nearly ten years of ultra-low interest rates and ultra-loose monetary policies set by global central banks, valuations across many asset classes have reached extreme levels. The Bank for International Settlements (BIS) likened market conditions at the end of 2017 to those of pre-2008 as investors became complacent, leveraging up risky assets to chase high returns. This is perhaps epitomised by the exceptionally low levels of equity volatility that persisted during 2017, which led to increasing numbers of investors taking direct exposure to short volatility positions via a handful of inverse volatility exchange traded products (ETPs). These blew up spectacularly on 5 February as the VIX spiked to 37 having been range-bound between 9 and 16 during 2017. Figure 1 shows the performance of one of the ill-fated inverse ETPs (XIV), backed by Credit Suisse, vs the VIX over the last three years.
In November 2017, the CEO of Credit Suisse, Tidjane Thiam, commented that “the only reason today to buy or sell bitcoin is to make money, which is the very definition of speculation and the very definition of a bubble”. The same could be said of some investors: betting that volatility would stay low forever is the very definition of speculation, and XIV’s 187% increase in 2017 is the very definition of a bubble. While the spike in implied volatility was the largest increase in percentage terms in the history of the VIX, in absolute terms it remained significantly below what was seen during the second half of 2008.
Towards the end of the quarter, inflation and rising rates fears were replaced by fears of an international trade war as the US government announced tariffs on steel, aluminium and Chinese imports. Having regained most of the losses following the events of the beginning of February, equities struggled, with the S&P 500 finishing the quarter –1.2%, –8.1% from its peak in January.
With the benefit of hindsight, being long equities (via an index) over the last nine years would have paid off handsomely, but can one really expect similar returns over the next nine years? After over a year and a half of extremely low equity volatility globally, the equity drawdown that began at the end of January was followed by higher volatility throughout the remainder of Q1. Whilst the initial shift to higher volatility appeared to be triggered by higher interest rate volatility and the unwind of the ‘short VIX trade’, more recently the focus appears to have broadened, with concerns relating to uncertainty surrounding global growth, monetary policy and a potential trade war.
The problem faced by many investors is where to put capital to achieve a positive expected return going forward. A certain amount of investor complacency had crept into the system; whether or not Q1 was just a preview of what is yet to come remains to be seen, however, investors have perhaps been reminded how quickly and sharply corrections can occur. Central banks will have to tread carefully when trying to unwind the excesses of the last ten years in order to avoid the blind panic seen during February.
The hedge fund industry as a whole has been criticised over the last few years, mainly due to many hedge fund managers failing to justify their fees. Aurum’s role is to identify top hedge fund managers that can justify their fees, delivering non-correlated alpha rather than market or generic factor-driven beta. While the broader hedge fund industry struggled during much of Q1, the performance of the underlying hedge funds held by Aurum was encouraging, particularly in March, bucking the trend when compared to the broader hedge fund industry (please see Aurum’s March Hedge Fund Snapshot). Nearly all funds managed or advised by Aurum were positive for the quarter, with most returning between +1% and +3% compared to -1% for the HFRX Global Hedge Index. A higher equity volatility and dispersion environment provides a more fertile environment for many systematic strategies and discretionary fundamental equity teams at multi-strategy funds. Increasing interest rates and an associated uptick in rate volatility should provide trading opportunities for both fixed income relative value and macro strategies. On the event driven side, 2018 has seen a very healthy level of deal flow and corporate activity so far. The current environment seems to be more accommodative to strategies favoured by Aurum.